Fixing bankers’ pay

By Felix Salmon

June 16, 2010

Squam Lake Report this afternoon, where Harvard's Jeremy Stein has just given a very compelling presentation on the subject of executive compensation at banks. His bright idea is that you don't regulate the level of pay at banks, and that you certainly don't try to convert pay into stock, for reasons similar to those glossed by Justin Fox at HBR:
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I’m at a conference on the Squam Lake Report this afternoon, where Harvard’s Jeremy Stein has just given a very compelling presentation on the subject of executive compensation at banks. His bright idea is that you don’t regulate the level of pay at banks, and that you certainly don’t try to convert pay into stock, for reasons similar to those glossed by Justin Fox at HBR:

Equity in a highly leveraged firm (banks and investment banks have debt-to-equity ratios that start at 10-to-1 and go much higher) is equivalent to a call option. That is, if the firm goes bust the equity holders only lose a little but if it does well they can reap huge rewards. So shareholders have every incentive to push executives at highly leveraged firms to take big risks (and executives with big equity stakes have every incentive to take big risks).

This conforms with what we saw at Bear Stearns and Lehman Brothers, where the managers had large equity stakes.

So what to do? “It’s important to get incentive alignment,” said Stein, between managers and taxpayers. And one way of doing that is to force a large part of executive compensation to be paid in cash — and then to hold back that cash for several years, to be surrendered in the event that the bank fails or receives exceptional government support.

Stein writes:

Familiar forms of deferred compensation, such as stock awards and options, do little to reduce the conflict between systemically important financial institutions and society. Managers who receive stock become more aligned with stockholders, but this does not align them with taxpayers. Managers and stockholders both capture the upside when things go well, and transfer at least some of the losses to taxpayers when things go badly. Stock options give managers even more incentive to take risk. Thus, compensation that is deferred to satisfy this regulatory obligation should be for a fixed monetary amount. For example, firms might be required to withhold 20% of the estimated dollar value of each executive’s annual compensation, including cash, stock, and option grants, for five years. At the end of this period, employees would receive the fixed dollar amount of their deferred compensation if the firm has not declared bankruptcy or received extraordinary government support.

The ECB’s Lorenzo Bini Smaghi, at the conference, was broadly sympathetic to this idea, but feared — as I do — that it might not be particularly effective: after all, 80% of bank-executive compensation is already more than enough for anybody, so they might not care enough about the other 20%. And five years might be too short, given the length of the business cycle. Still, it’s a start.